Europe Attempts to Learn its Lessons from the Sovereign Debt Crisis and Guard Against Rating Procyclicality
The European
Sovereign debt crisis, which engulfed the EU after the Financial Crisis,
left an indelible mark on the structure and mentality of those charged with
leading the bloc. Now, as the bloc faces yet another crisis in the form of the
COVID-19 pandemic, it appears that the leaders of the EU and, in particular the
ECB (European Central Bank), have learned their lessons from 2012 and are
taking proactive actions against the coming wave of downgrades. However, have
they really learned their lesson? Also, what are the risks that the EU is
opening itself up to, financially, as well as politically? In this post we will
review the unscheduled announcement recently by the ECB that it will now be
accepting the bonds of so-called ‘fallen angels’ as collateral.
It is being widely reported in today’s business press that
the ECB will, as long as a so-called ‘fallen angel’ was deemed investment-grade
on and before the 7th April and that they remain as BB-rated (or the
equivalent), accept those bonds as collateral within the ECB’s ‘collateral
framework’. This, essentially, refers to the process whereby the ECB will allow for credit
to enter the financial system, but provides the ECB with some level of
protection. The ECB itself declares that ‘the collateral
framework of the central bank is therefore important not only for risk
protection and the feasibility of central bank credit operations, but also for
financial conditions, financial stability and the transmission mechanism of
monetary policy, in particular in stress situations’. However, how does the
ECB know what collateral is worthy of being used within that framework? There
are a number of options available to them, but one of the more common measures
is a bond’s credit rating, as provided by the leading credit rating agencies.
With the cut-off being the so-called ‘investment-grade’
demarcation that all rating agencies have, the situation is rather simple.
However, in the current situation (as we have spoken about before here
in Financial Regulation Matters),
there are a number of bonds and entities that sit either on the precipice, or
have fallen below it. Those that have fallen below it are deemed ‘fallen angels’.
With the rating agencies being criticised for rating potentially suspect
entities as investment-grade in the ‘good times’ because those entities pay the
agencies for their ratings, the natural knock-on effect of that is that when
times go bad, those that have had their ratings inflated will quickly drop into
non-investment grade; the result of this is that it is both harder for those
entities to access credit, and that their bonds become ineligible to be used as
collateral for other things. One of those things is accessing credit from
central banks. However, in the current climate it is crucial that central banks
maintain their function and maintain a level of liquidity within the financial system.
So, to that end, the ECB held an unscheduled call of the ECB’s governing
council on Wednesday in order to approve an alteration in their processes; that
alteration was that now the ECB will accept the bonds of fallen angels as collateral
within its framework. Furthermore, the ECB announced that ‘the ECB
may decide, if and when necessary, to take additional measures to further
mitigate the impact of rating downgrades, particularly with a view to ensuring
the smooth transition of its monetary policy in all jurisdictions of the euro
area’. Whilst a decision like this would not have been made hastily, it
does appear to have a sentiment of haste about it. Why? The financial press
have probably rightly made the connection between this move and the fact that
S&P is due to deliver its next rating action on Italy and its sovereign
bonds on Friday, which the prediction being that it will be going downwards. Although
the two elements are separate, in that the ECB is providing waivers for the
sovereign debt of certain countries like Greece, with Italy’s debt expected to
be included in that, the general pressure on the EU is ramping up and the
rating agencies are playing a central role in that pressure, as is their
function.
The US Federal Reserve has taken similar measures in buying
up ‘junk bonds’ in its asset-purchasing programme. Experts have noted the
increasing rate of debt issuance around the investment-grade precipice, with
UBS stating that European bonds rated BBB- (one notch above junk status) have
risen from €330 billion in 2011 to €1.14 trillion, with BB rated bond issuance
(junk status) also rising by €110 billion in that same time period; the
sentiment is that the massive amounts of BBB-rated bonds could quickly become
ineligible within collateral frameworks. Although the ECB has announced that
so-called ‘haircuts’ will be applied to junk bonds so that their value is
reduced as collateral, not many in the financial press are looking at the
obvious issue. In Bloomberg, Marcus
Ashworth noted that ‘as
with the Fed, it’s a worrying this for the ECB to be holding ever more risky
credit’. He qualifies this by saying that ‘but these are truly dangerous
times for the economy. We’ll just have to fall back on the hope that these are
temporary measures until the world recovers’. Whilst I am not sure I have ever
read an economics paper that talks about the importance of ‘hope’ within an
economic system, the situation for the EU is stark. With the central bank
eating up more and more ‘risky credit’ for no other reason other than it must
do so to keep up liquidity in its system, this fact when adjoined to the politically-fraught
situation that is developing within the bloc regarding assistance for all of its members presents a really
pivotal period for the bloc. Only this morning did Angela Merkel state that the
pandemic is a threat
to democracy as Europe knows it and, despite sounding particularly
dramatic, she is probably right. There appears to be plenty of faith being put
in the concept of ‘hope’, and also in refusing to accept the ratings of the
agencies. While the agencies’ detractors will no doubt state that this is what
should happen, the message the ECB is sending is rather strange – we will use
the ratings during the good times, but not in the bad. The effect of that
approach, both economically and politically, remain to be seen.
Keywords – credit ratings, EU, collateral, economics,
finance, @finregmatters
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